Private Equity disputes: three trends emerging from the post-boom reality

The Private Equity market has spent much of the last few years adjusting to a world very different from the one in which many deals were struck in 2020 and 2021. Cheaper debt, more abundant liquidity and aggressive growth assumptions have given way to higher financing costs, slower growth and greater scrutiny of investment performance.

From a Disputes perspective, the consequences are beginning to crystallise, and we have observed three broad recurring themes emerging across Private Equity and PE-backed businesses:

• Value that was deferred into the future is increasingly becoming the subject of dispute.
• Buyers are becoming more forensic in assessing whether they received what they bargained for.
• Expansion of PE-backed consolidation strategies, particularly within professional services, is creating a different category of repeat disputes centred on client ownership, integration and restrictive covenants.

Taken together, these trends suggest that many of today's disputes are not new problems at all. They are the delayed consequences of transactions negotiated in very different market conditions.

1. Value delayed is value disputed

Over the past several years, we have seen an increasing number of disputes concerning contingent value mechanisms.

The years immediately following the pandemic saw significant valuation optimism in many sectors. Where buyers and sellers could not agree on price, earn-outs, deferred consideration arrangements and management equity structures became useful tools for bridging the gap.  Industry commentary notes that economic uncertainty and valuation mismatches have made earn-outs a common feature of Private Equity transactions, particularly where parties held differing views on future performance.

The Disputes lawyer's perspective is that those kinds of arrangements work well, as long as growth broadly tracks expectations. However, in many cases post 2021, this has not been the case it did not or has not.

As earn-out periods have matured, disputes have emerged around whether targets were achieved, how performance should be measured and whether post-acquisition decisions have unfairly reduced seller entitlements.  Market commentators have identified disagreements over operational control, accounting treatment and the buyer's management of the acquired business as recurring causes of conflict and that matches what we have seen.

The timing is noteworthy.  Many earn-outs or deferred consideration mechanisms agreed in, say, 2020 and 2021 were structured over periods of between two and five years. A significant number have therefore reached their critical assessment points against a backdrop of inflation, rising interest rates, recruitment pressures and weaker growth than originally forecast.

The same dynamic can be seen in disputes concerning management incentive arrangements.

Private Equity transactions are frequently built around the principle of alignment.  Management invests alongside the sponsor, accepts a lower cash-out at completion and participates through rollover equity or sweet equity in the expectation of sharing in a future exit.  That alignment can become strained when growth disappoints, exits are delayed or valuations fail to materialise as anticipated.

In practice, disagreements can arise over leaver provisions, dilution, vesting arrangements and the interpretation of incentive structures.  These matters do not always progress to litigation, but they increasingly form part of the contentious landscape surrounding underperforming investments.

More broadly, many of these disputes reflect a simple reality. Risks which might previously have been reflected in headline price were deferred into contingent mechanisms. Once the future arrived, the parties discovered they had fundamentally different expectations as to where that risk should sit.

2. Buyers are becoming more forensic

A second trend is the increased willingness of buyers to scrutinise acquisitions after completion.  Warranty claims are not a new phenomenon by any means.  However, our anecdotal observation based on caseloads is that whilst, historically, many warranty claims never progressed beyond initial correspondence, and commercial pragmatism often prevailed, there are signs that this may be changing.

Across both Private Equity and wider M&A transactions, buyers appear increasingly willing to examine closely whether acquired businesses match the picture presented during the deal process. Perhaps less charitably, in tougher markets, every penny counts. At the same time, commentators are reporting greater activity around representation and warranty insurance claims and disputes concerning post-closing remedies.

Several factors may be contributing to this.

First, acquisitions completed during more buoyant markets are now being evaluated against actual rather than projected performance. Where a business underperforms, buyers are naturally asking whether the cause is changing market conditions or whether relevant issues ought to have been disclosed before completion.

Secondly, as transaction volumes have fluctuated and holding periods have lengthened, investors have had greater opportunity to conduct detailed reviews of portfolio performance.

Thirdly, the widespread use of warranty and indemnity insurance has altered the commercial landscape. Buyers may be more prepared to investigate potential breaches where routes to recovery exist and where pursuing a claim is no longer viewed solely as an attack on the seller.

Whatever the cause, buyers appear increasingly focused on enforcing contractual protections. The result is not merely more claims, but a greater willingness to undertake the investigative work necessary to determine whether claims exist at all.

In many respects, this reflects a broader maturation of the market. As margins tighten and exits become harder to achieve, every source of value matters. If a buyer believes it did not receive what it bargained for, there is a growing inclination to test the contractual position rather than simply absorb the loss.

3. The new battleground in PE roll-ups

The third trend is somewhat different. While the first two themes concern historic transactions, this theme concerns the changing nature of Private Equity investment itself.

We have seen, particularly in the post-pandemic period, significant interest from PE firms in fragmented professional services sectors, including legal services, accountancy, wealth management, financial advice and other advisory businesses. Industry analysis consistently points to recurring revenues, strong client retention, predictable cash flows and buy-and-build opportunities as major drivers of investment activity.

As these platforms grow through acquisition, disputes relating to restrictive covenants, team moves and client solicitation are becoming increasingly common. As a result, many acquisitive businesses have had to develop processes to manage these issues as they continue to expand.

However, the most interesting lesson from these disputes may not be their legal outcome. In many cases, restrictive covenant litigation is merely the symptom rather than the disease.

The underlying commercial challenge is post-acquisition integration. The value of an acquisition of a client bank, backed by restrictive covenants is a period of exclusivity during which the buyer it can integrate those clients into its wider business, making those clients its own.

The investment thesis behind most roll-up strategies depends upon creating a business which is worth more than the sum of its constituent parts. This requires the integration of clients into the wider platform, with relationships being shared across teams and value becoming embedded in the organisation, rather than resting with individual founders or fee earners.

Where that integration is successful, the departure of a key individual is inconvenient but manageable. Where it is unsuccessful, restrictive covenants suddenly become critically important because client relationships remain concentrated in particular individuals. Litigation then becomes an attempt to preserve value, which should arguably have been secured through operational integration years earlier.

For investors pursuing buy-and-build strategies, particularly in professional services, the lesson from the view of the litigator is that client integration is a more effective risk-management tool than any restrictive covenant drafting exercise. A covenant may help contain damage after a departure. Integration prevents damage arising in the first place.

Conclusion

Although the disputes themselves vary, a common thread runs through many of the contentious matters now appearing in the Private Equity market.

The optimism that characterised many 2020 and 2021 transactions, pushed a significant amount of value into the future through earn-outs, deferred consideration arrangements and management equity structures. As those mechanisms have matured, disagreements about performance and entitlement have been inevitable. At the same time, buyers are becoming increasingly rigorous in examining whether acquired businesses delivered what was promised and are more willing to pursue contractual remedies where they believe they have not. Meanwhile, the growth of PE-backed consolidation strategies is generating a fresh set of disputes around client ownership, integration and talent retention.

The result is not necessarily that parties are becoming more contentious. Rather, the economic assumptions underpinning many transactions are being tested. When those assumptions prove inaccurate, the transaction documents become the primary battleground for determining who ultimately bears the risk. This is likely to remain a defining feature of mid-market Private Equity disputes for years to come.